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Apple’s $3 billion purchase of Beats Electronics was an uncharacteristic move for a company that has typically limited its acquisitions to small start-ups. In fact, its last high-profile buy was in 1996, when Apple purchased computer company NeXT and in the process brought previously ousted founder Steve Jobs back to the firm. Announced last week, the purchase of Beats, which was founded by rapper Dr. Dre and music industry executive Jimmy Iovine, brings into the Apple fold an audio hardware business, including Beats’ popular headphones, and the company’s streaming music service.

As Apple’s Worldwide Developers Conference kicked off in San Francisco this week, Knowledge@Wharton spoke to Wharton marketing professor Peter Fader about how the company can successfully leverage Beats’ strengths and why the acquisition could prove to be a boost for the entire streaming music space.

An edited transcript of the conversation appears below.

Knowledge@Wharton: We’re here today with Wharton marketing professor Peter Fader to talk about Apple’s recent acquisition of Beats. The acquisition came with the purchase of the Beats streaming music service and its hardware business. Pete, thanks for being with us today.

Peter Fader: Glad to talk to you.

Knowledge@Wharton: What do you think was Apple’s strategy behind this acquisition?

Fader: It’s a very unusual move for Apple to go out there and work with a different firm, something that’s going to require them to open up and actually accept other people’s standards and lose some of the control that they insist upon.

More than anything, I think it’s an acknowledgement that iTunes just hasn’t worked for them. I think the original business model — focusing on those 99-cent downloads — was really an utter failure for the music industry as a whole. They finally waved the white flag. They’re moving to the streaming subscription space, something Apple said it would never ever do before. Their own efforts to do that with iTunes Radio weren’t working very well, so it’s not clear that this is going to be any better. But it is a sign that they acknowledge some of their failings in this space.

“This acknowledgement that the download model is over and that it’s all about streaming [is] going to force the industry as a whole to embrace streaming in a bigger, more aggressive, more proactive way.”

Knowledge@Wharton: Does this represent a change in Apple’s innovation strategy, i.e., that they’re now going to be innovating through acquisition as opposed to innovating internally? And what does that mean for the company?

Fader: It’s a huge change in this regard. In fact, if we change the cast of characters a little bit — suppose we said that Microsoft was buying Beats instead — everyone would laugh at it. Everyone would say, “Uh-oh, here comes another Zune…. They’re buying a company because they can’t invent things on their own.” [Beats is] a company that has a very small base when it comes to the subscription side. So you know that people would call it desperation on the part of Microsoft and would declare the merger dead before it ever got off the ground.

I think … we have to take into account who’s doing the acquiring more than what’s being acquired here. Because Apple’s doing it and because it is such an unusual move for them, there are a lot of people who are willing to give them a lot more slack than they might if it were Microsoft or another company on the other side of [the deal].

Knowledge@Wharton: Apple also has its Worldwide Developers Conference this week — what is at stake for them there? What do they have to do, either as it relates to their current technology or around the Beats acquisition, for people to continue to feel optimistic about the company and about this particular acquisition?

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Fader: Well, of course it’s always hard to say. We never know exactly what’s going to come out of one of their developer conferences. I think that the news about Beats and the new iOS, all that stuff is nice and interesting and it will give people something to talk about. But all eyes are on the potential iPhone announcement. If they come up with [a phone that has] the big screen, that could be a game changer, at least for Apple, because we know that it’s been a game changer for everyone else.

And once again, Apple wouldn’t admit it to the outside, but internally they’re probably saying, “Man, we should have come up with one of those big screens a long time ago.” One of the reasons why Samsung has caught up and in many ways surpassed them [in the smartphone sector] is simply because of the size of the screen, forgetting about anything else.

If you can take the larger screen and combine it with some of the other still-unique aspects of the Apple phone experience, you might have a great device that will make these other stories really moot. No one will be paying attention to [the other stories] if they do make an announcement like that.

Knowledge@Wharton: How important is it that the Beats acquisition includes that company’s streaming music service?

Fader: I think that’s why they made the acquisition. The Beats product is a very nice one. There is no question about it: [Apple] bought Beats because iTunes radio wasn’t working. No one is downloading music anymore. Beats is big enough that it’s a real brand name; it has some cachet. But it’s small enough that Apple can supposedly mold it into something that would be more of an Apple branded service than just Apple being tacked onto an existing brand.

But the problem is that Beats is so small that Apple is going to have a really hard time competing with Pandora and Spotify and some of the other bigger players out there. It’s not clear whether they can take this small service and turn it into a giant one, whether the Apple name is enough to do that, when the Apple name wasn’t enough to make iTunes work.

Fader: In that regard, this is the most wonderful “I told you so!” story that I’ve heard in a long time. I’ve been calling for this for truly over a decade and even went as far as saying that one day, when Apple announces that it’s getting into a streaming subscription model in a big way, not only will they do well with it, but it’s going to be a rising tide that’s going to lift all boats. It’s going to legitimize streaming in a way that it hasn’t been fully legitimized. A lot of people are waiting for Apple to give this kind of big blessing.

“It’s still unusual for [Apple] to work with outsiders, but this is about as good an outsider as they can find when it comes to hardware.”

Now again, Apple has taken some steps in that direction with iTunes Radio, but no one really paid any attention to that. By doing it with a brand [like Beats], by having a more established service, I think that’s actually going to help Spotify, Pandora, everybody else out there. And it might end up actually helping those other services more than it actually helps Apple itself.

Knowledge@Wharton: Why do you feel that way?

Fader: Because a lot of people have been waiting and seeing [and saying], “You know, I’m not quite sure I want to jump onto Spotify, because I own an iPhone and I want to do whatever the iPhone offers me.” More iPhone people are using Pandora or Spotify than they are using iTunes Radio. But there are still a lot of folks who are just holding out hope that Apple would have a world-class entry into the streaming music world. Beats might be that one. But again, it now gives a green light to these other [streaming services], and it’s also going to encourage the industry to be a little bit more accepting, a little bit more progressive.

I don’t want to say that [Apple has] stood in the way of Spotify and Pandora, but they haven’t made life easy for those other services. I think this acknowledgement that the download model is over and that it’s all about streaming [is] going to force the industry as a whole to embrace streaming in a bigger, more aggressive, more proactive way than they ever did before. So it’s going to help everybody in the industry, but especially consumers. Consumers are much better off using these services. I don’t even care which one. We can nitpick about any of these big ones. They’re all good. And they’re all a much better consumer experience than a la carte downloading.

Knowledge@Wharton: Apple had kind of a ho-hum product in iTunes Radio, at least based on the consumer response. And now they’ve acquired Beats, so they’re going to get access to subscribers or users of Beats Music. What do you think Apple needs to do to take these two services and really stand out in this market? Because they’re entering a market that has a lot of established players with Pandora, Spotify, Rdio and others.

Fader: It’s a very good question and a very difficult question, because usually, whenever Apple announces something it just turns to gold. There are just enough people out there — whether it’s because of true love for different Apple products and services or maybe out of inertia — [who say] … “I’m just going to go with the one that Apple endorses.” That’s usually the way it works. But it didn’t work with iTunes Radio, and it’s not clear that just moving to a different horse, that putting the Apple name on Beats instead, or in addition [to iTunes Radio], is going to lead to a dramatic difference. But it does signal that Apple is going to be investing a whole lot more in this space than they were before. It could be that some of the disappointments with iTunes Radio weren’t so much the service itself, but that it really wasn’t a major focus for Apple. Maybe this is a sign that they’re going to get serious about it.

And whether it’s the Beats platform itself or just Apple’s increased seriousness, that might help them. They’re going to have to advertise heavily and do all kinds of things that don’t come naturally for Apple. We’ll see how well they do. But it is going to be a much tougher challenge for them than other areas where they’ve been successful to date.

“On one hand, you could say this is an admission of defeat and that Apple can’t innovate on its own and can’t develop best-in-class products and services. On the other hand, you might say the reason why they haven’t gone to the outside is a bit of arrogance.”

Knowledge@Wharton: Is that because instead of being the market creator or the market buster, Apple is going to have to see what everyone else has done and follow on someone’s coattails, when they haven’t done that before?

Fader: That’s a big part of it. It’s a rapidly commoditizing business. It’s not clear that Apple can go in and truly shake it up in a disruptive way [like they were] able to do with the iPad and the iPhone. This is not something they’ve been very good at — that is to say, a service of this sort. But Apple is a smart company, and they’re a very resourceful company. And if they really do set their mind to it, then they need to be taken seriously. But it’s not clear that they’re going to be able to jump right to the top, and convince people to actually give up on Pandora or Spotify, or some unauthorized service that they might be currently using, and jump over to [the Apple product]. It is possible, but put it this way: I wouldn’t bet on it.

Knowledge@Wharton: What about the hardware and talent sides of the Beats acquisition? How can Apple deploy those effectively?

Fader: The Beats headphones are a fine product and, in many ways, it’s a very good fit with Apple. It is just a best-in-class product where price is no issue: If you want the best, this is going to be the thing that you buy. So there is a good fit in that regard. And even some of the design elements are aligned well with Apple. So I think that they can make Beats — the hardware side — fit quite well under their umbrella.

It’s still unusual for them to work with outsiders, but this is about as good an outsider as they can find when it comes to hardware. But how much interplay there is between the hardware and the software — and there has been a lot of speculation about how much of their reasons for the acquisition was the hardware versus the software — that remains to be seen.

Knowledge@Wharton: What about the talent side of this? Do you expect to see them using Dr. Dre or Jimmy Iovine in a particular way? Or are they mostly figureheads who lend street cred to Apple?

Fader: I think that’s right. I think that it’s more to show that [Apple is] cool and that it’s endorsed by folks who are respected within the music industry. But I don’t think that those particular folks are going to be game changers in any way. They’re respected; there’s no question about it. But I don’t think that consumers are going to say, “Now there’s a reason to be switching to the Beats service instead of other services.” Because let’s face it: Those guys and the whole Beats team have been associated with the company all along, and that wasn’t enough to get Beats even within an order of magnitude of Spotify or Pandora. So it’s not clear that attaching those names to Apple is going to really change anything.

Knowledge@Wharton: How do you see this acquisition fitting into Tim Cook’s performance as Apple’s CEO overall? What does this say about the direction that his leadership is going in, and what do you think are going to be the challenges for him as this goes forward?

Fader: It’s an interesting, historic moment because on one hand, you could say this is an admission of defeat and that Apple can’t innovate on its own and can’t develop best-in-class products and services. On the other hand, you might say the reason why they haven’t gone to the outside is a bit of arrogance, that they’ve always just felt they could do it better. But you know what? There are times when it makes sense to partner and to acquire.

The fact that they’re open to [looking to the outside], does that represent desperation? Does that represent opportunity? I’m not really sure. But we’re going to look back at it within the next few years and say, “Oh, it’s real clear that it was one or the other.” It is a pivotal moment, and I think there is a lot riding on it. It might be a precedent that then gets followed in other unimaginable ways. But it’s a big step forward for Apple.

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2 Comments So Far

M. Bonbon

Could Apple be on the same downward spiral path as Sony? The K@W May 21 article about the latter’s fall from the top of the same consumer electronics market following the departure of Akio Morita sounds ominously similar.

Anonymous

One of the things that made Apple such a force was the synergy between the creative genius of Jobs and the operational excellence of Cook, that dynamic is now missing. I believe what we are witnessing is the gradual movement away from the creative leadership towards operational tyranny, the drive for profits over products, management over leadership. You see this everywhere; releasing a half baked maps program, the 5c(cheap) and now this. I’m sure the senior leadership team at Apple has done their homework and blessed this, what’s missing is common sense but hey what a great operations play, make vs buy kind of thing.

Sony is a good parallel, they were the unrivaled consumer electronics company then slowly slid into irrelevance as they cheapened their products to capture volume over margin. It’s a good time to think about shorting Apple’s stock.